Blockchain

1. Fintech
Week 6
Dr Drago Indjic
QMUL
24 November 2019

2. Syllabus
1. Digital Transformation of Financial Services
2. Regulation: law, community, platforms
3. Identity: Customers, Citizens, Privacy
4. PayTech: Money, Payments
5. Blockchain: Coins, Tokens and Contracts
6. WealthTech: Personal Services
7. Infrastructure: Services, business, wholesale
8. Innovation: Entrepreneurship and Strategy

3. Last Week Crypto Market Trouble
• Why?

4. Law and Economics (Complexity)
• “Code is Law”: Centralised, permissioned or
• Swarms of crowdfunded robo-litigation drones?

5. Pedagogy (of the Oppressed)
• Primarily focus on crypto-currencies and not digital securities
• Un-banking: Money – wallet - account – bank
• “Why” Bitcoin is arguably more interesting question than “how”
• Innovation and scalability
• The principal one is fragility of trust that scales poorly
• trust-minimized, max privacy, decentralisation of power
• All banking data is concentrated in just a few global banks
• “too big to fail” banks and/or manipulated by either malicious agents or a state itself
• Governance challenges of a global, techno-social system
• From postal system to phone (“to connect, dial +86”) and Internet

6. Un-Banking
• “BTC is globally available money with pre-defined algorithmic supply”
• more difficult to counterfeit, more divisible, transferable, scarce and fungible,
where every user (peer) can verify every transaction of the “base” money
• Bank of International Settlement (Basel), AliPay et al are centralised
• Note: fintech, hence we are not teaching (history of) money and banking
• One single authoritative sequence of transactions (TX) can be agreed
by all new participants
• Avoid Winner Takes All and Lender of Last Resort
• Let’s enjoy watching a short BBC Click video (2016)
• https://youtu.be/SzAuB2FG79A

7. • Someone (“Alice”) sends you money, everyone confirms it and
everything is legitimate
• Everyone’s balances are written and transaction are signed by a private key
• https://www.blockchain.com/explorer
• The network is secure and trusted
• It cannot be shut or controlled. The decentralised ledger and the consensus
protocol (i) controls the issuance of a rare digital asset by deterministic,
asymptotic supply (monetary policy) and (ii) enables (personally signed)
transactions carried through an open, permission-less (“opt-in”) nodes.
Short Film Review

8. Young Age: #Economic Cycles
• Focus on BTC
• Born on 3 January 2009. Parents: Unknown. Nationality: ?
• Embedded in the coinbase of the zero block was the text: The Times
03/Jan/2009 Chancellor on brink of second bailout for banks.
• ETH (đ)
• Conceived by Buterin (2013), pre-mined (July 2014), born 30 July 2015
• Other crypto avenues
• Smart contracts => stablecoins
• Anonymity-enhanced cryptocurrencies

9. Trust and Delegation
• Safe-keeping: safe with you, or elsewhere? Vote now?
• “Not your (private crypto) keys, not your coins”
• Safe Custody: Aggregation
• Economies of scale
• Q. Goal – if financial - why holding?
• Capital formation problem: premine, convert or earn?
• Changes like bug fixes, hash migration?

10. Blockchain Tech: “On Chain”
• Architecture: three layers – protocol, network, and data
• The networking and cryptography intuitively understandable
• not PoW
• Core Algorithms: cryptography + consensus protocol
• Logical components: blockchain, Proof of Work (PoW), peer-to-peer
communication, digital signatures, hashing
• Requirements
• computational power, memory, network …
• Governance … e.g.
• https://eng.ambcrypto.com/ethereum-classic-rejects-progpow-while-sha-3-gains-
majority-support/

11. Blockchain: Computer science
• Description:
• a chain of (i) block data structure with
• (ii) Merkle trees (1979) made up of
• (iii) hashes secured by
• (iv) cryptographic SHA (2001, NSA) function
• Note
• external code libraries used
• PoW leads to centralisation: 50+% hash power in the Top 4 BTC and Top 3 ETH
mining pools (located in China)

12. Demo: Hashing
• For example, try any web hash demo like
• https://passwordsgenerator.net/sha256-hash-generator/

13. Consensus + Challenge
• Governance and incentives mechanism design
• Never forget “off chain” reaction
• Byzantine Fault Tolerance (BFT)
• Consider that some of the involved parties are corrupt and
disseminating false information or are otherwise unreliable.
• Pre-Nakamoto (1982) - the Nakamoto designer(s) likely unaware
• Difficulty: “puzzle” in Nakamoto design

14. Satoshi Consensus Protocol Narrative (1)
• One single authoritative sequence of transactions (TX) can be agreed
by all new participants
• TX history is authored in blocks, each block summarising the last 10
minutes of network activity, by a single one of many network
members/participants called “miners”
• Thus Internet “time” and clock synchronisation is critical
• The selection of a single one out of many possible miners to
determine the next block of TX history is based on a competitive race
to solve a puzzle
• An increasingly difficult, costly and entirely useless “Proof of Work” (PoW) computation
• Not green: monumental waste of energy (unless coolers repurposed for heating)

15. Proof of Work: “Mining”
• “Mining” ensures security according to the consensus rules
• Energy is spent/wasted each time a miner creates, submits a candidate block and hashes
it through PoW: a difficult work to produce but easy for others to verify (by consensus)
• guess a random number (aka nonce) s.t. sha256(sha256(data+nonce)) < difficulty
• Hashcash PoW on all of the data in the block
• The difficulty of PoW is adjusted to match 1.6 mHz network rate. Low probability of
successful generation makes it unpredictable which miner will be able to generate the
next block. For a block to be valid it must hash to a value less than the current target;
this means that each block indicates that work has been done generating it. Each block
contains the hash of the preceding block, thus each block has a chain of blocks that
together contain a large amount of work. Successful miner receives fee reward.
• TX are immutably captured like “flies in amber” (Szabo). Changing a block (which can
only be done by making a new block containing the same predecessor) requires
regenerating all successors and redoing the work they contain. Impractical.

16. There is only one BTC
• Other (4000+) blockchains offering “alternative” tokens with different
economic/business models, distribution mechanisms, hashing and
consensus protocols

17. Bitcoin Use Cases
• Note: custody - “Not your keys, not your coins”

18. Crypto Exchanges: New Prime Brokers
• Prime broker = brokerage + leverage + custody
• The “professional” space: often supported by banking relationships required
for conversions into fiat money. Notably, all known BTC hacks happened at the
exchanges rather than at blockchain itself.
• The investors are fiduciaries, holding an asset, and should be earning
inflation to preserve their pro-rata share of the network.
• Informational asymmetry: most “hodlers” do not have the capacity to track,
and participate in staking across numerous protocols
• Risk: the exchanges running fractional reserves
• A dozen PoS protocols with a network value of over $100M that deploy a
staking function represented a collective network value of nearly $9 billion,
and an average staking rewards of roughly 5% per year.

19. Bitcoin (Non-)Privacy
• BTC relies on everyone being aware of every transaction
• Auditing the blockchain requires the full, unabridged ledger
• Not private: explicitly identifies an address as the origin of a payment. The
only protection is that there are no real names. The base layer doesn’t even
attempt to obfuscate transaction data.
• Privacy-coins: XMR, ZCH
• Decoy-based: TX is disguised by selecting a number of possible payment
origins. Monero’s RingCT require to explicitly verify the source of your funds,
but it is hidden by including a handful of decoys that aren’t the real source.
• Privacy designs may be prone to undetectable supply (inflation – the
auditable supply) and coin theft: trade off between privacy and integrity, or
fungibility and anonymity .

20. Bitcoin Great Fall
• Person-to-Person paytech: nor MoX neither inclusive
• Not an “internet cash”: not risk-free, un-defaultable, instant finality
• TfL and AliPay are simply better paytech
• Not SoV: HODL, “digital gold”, uncorrelated … volatility
• Privacy and anonymity: Censorship resistance, privacy
• Institutionalisation
• Institutional commodity
• CME BTC futures & options;
• BitMEX, Deribit: fees, payout, reference index
• Alexander, C. et al (2019)

21. Etherium
• “World Computer”
• PoS is greener
• https://github.com/ethereum/wiki/wiki/Proof-of-Stake-FAQ
• “Code is Law”
• Open governance challenge
• “Smart” “Contracts”: security protocols that exercise change of control over
things, conditional on the performance and the state of the world. The
possession is the major factor; actual rights and obligations are negotiable -
notably, not constrained by traditional legal norms and legal logic.
• Ðapp and tokenenomics revolution: cost of contracting (Coase)

22. Future - Governance
• Financing development and timing forks are contentious issues
• There can be only one PoW chain - the history of work paid in real energy cost
• …. but many forks and layers.
• “Code as law” and protocol updates (“forks”)
• Are the core developers secretly attempting a coup, making backdoors?
• Decentralization is not “free”
• Consensus protocols do not completely solve the problem of balancing
security and resource efficiency.
• Storage
• the ordinary nodes eventually run out of storage as TX data keep growing

23. Game #1 – Consensus resolution
• Thanks to Alex Matanovic (ECD)
• Takes 10 minutes
• In 10 sec intervals, each student is given 3 sec to memorise a random
number (e.g. a 7 digits “code”), to write it down at her/his desk and
leave a note (“vote”) at the back. Check the consensus vote and the
error rate.
• Advanced version: a Round Robin chain passing messages that include a few
cheaters

24. Game #2: Chocolate-Chain
• Roles: “Satoshi” (a narrator as the network algorithm), two people
from the audience as “Miners” and other students are “wallets”
• Stage: The Room (as Internet). Everything is publicly visible: whiteboards,
people, clock.
• Takes 45 mins with a small group, with 50+ students today cannot be
played
• Can be offered as a module of the future Blockchain elective 2020/21

25. An Example of Crypto User Experience
• Choose your crypto wallet
• https://jaxx.io/, https://www.coinomi.com/en/ are multi-platform
• https://www.blockchain.com/ is mobile only.
• Install app
• Create your wallet address, backup it.
• Try to fund by a token amount (£1) – choice of crypto exchange may be tricky
• Try sending each other a small transaction.
• Try block explorer (https://www.blockchain.com/explorer) to visualise the
executed transaction: addresses, amount, fee, block number, size, time, hash,
everything but a name.